The house-of-cards style collapse of major crypto firms like Celsius and FTX in 2022 has increased the urgency to regulate cryptocurrencies. The multi-fold increase in crypto-related scams to the tune of $20.1 billion has only added fuel to the fire.
But regulating cryptocurrencies is easier said than done. At the heart of the problem lies one question: How to classify cryptocurrencies?
Lawmakers and regulators in the US disagree on whether to treat and regulate crypto as securities, not commodities with fewer regulatory burdens. Those in favor, such as SEC Chair Gary Gensler, argue that most cryptocurrencies, apart from perhaps BTC, meet the criteria of something they use to classify and regulate financial products: the ‘Howey Test.’
How to Determine Whether a Financial Contract Is a Security
The “Howey Test” lies at the center of the entire debate against cryptocurrencies.
This test emerged from the U.S. Supreme Court ruling in the 1946 Securities and Exchange Commission vs. Howey Co. case.
Howey Co. sold contracts in which investors would buy citrus groves from Howey Co. and lease them back to the company. Howey Co. would then tend the trees and sell the fruits, and the investors would earn a share of the profits.
In the lawsuit, which the SEC won, the markets regulator argued that the contracts qualified as securities.
From this ruling came the Howey Test. According to the Howey Test, an investment is a security if: a) you use money to buy a product or service; b) others have invested in the same product; c) you expect to make a profit; and d) this profit is due to the actions of an identifiable third party.
Crypto and Howey
Regulators argue that most cryptocurrencies meet the criteria of the Howey Test except the last point — an identifiable third party.
For instance, in the case of Bitcoin, there is no single third party to attribute the profits to — a sprawling array of computers runs the network, and the creator, Satashi Nakamoto, hasn’t been around for over a decade.
But that’s not the case for most cryptocurrencies, many of which start out relying on a small group of individuals who would qualify as that “identifiable third party.”
Additionally, Gensler has implied that the consensus algorithm of a blockchain could influence whether it would be classified as a security.
In 2018, when Ethereum was secured by a proof-of-work consensus algorithm, SEC finance director William Hinman said in a speech that Ethereum is probably not a security, since it is “sufficiently decentralized.” Purchasers could “no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial effort.” You can also translate this to: “Regulations don’t have a single entity to target and regulate.”
However, in 2022, after Ethereum switched to a proof-of-stake consensus algorithm, which allowed investors to earn interest or yield for staking their coins, Gensler said that any cryptocurrency and intermediary that allows staking would likely pass the Howey Test.
Apart from major blockchains, most initial coin offerings (ICOs) are also considered securities offerings since investors essentially invest in a project or company with the expectation of earning a profit. It’s pretty similar to how the stock market works — so it’s not surprising that the SEC would lean toward classifying them as securities.
What’s the Big Deal About Crypto Being a Security?
So, why is it a problem if crypto is classified as a security, rather than a commodity? It’s because securities are subject to federal regulations — such as disclosure requirements, anti-fraud provisions, and investor protection mechanisms. Crucially, some securities can also only be sold to “accredited investors”—people with a gross income that exceeds $200,000.
Some argue that these requirements, along with the hefty fines levied on platforms deemed to have sold unregistered securities, “stifle innovation” and unfairly deprive less moneyed investors of lucrative market opportunities. The regulators argue that they are merely protecting investors from ruinous loss of wealth.
The Current SEC Stance
In 2022, Gensler said that the “vast majority” of cryptocurrencies are securities. This follows the overall tightened regulatory approach of 2022 when the SEC increased its actions against crypto firms for unregistered securities offerings by over 50%. The most famous of these actions is the one against Ripple, in which the SEC claims that XRP is a security.
In December 2022, the SEC declared FTT, the native token of the bankrupt crypto exchange FTX, a security. In its argument, the SEC said, “If demand for trading on the FTX platform increased, demand for the FTT token could increase, such that any price increase in FTT would benefit holders of FTT equally and in proportion to their FTT holdings.”
This could further indicate that exchange tokens, like BNB of Binance and OKX’s OKB, may also be considered securities.
The SEC also used a Coinbase insider trading case as an opportunity to name nine crypto assets it deals in as securities.
What Now, Howey?
The SEC has provided guidance on specific crypto cases but hasn’t updated its framework for determining the legal status of cryptocurrencies since 2019.
Plus, some of its guidance on securities has been inconsistent, such as the possible flip-flop on the regulatory status of ether. And some of it can be quite nuanced. Gensler has said he believes that stablecoins, which don’t have an obvious profit expectation, should be treated as securities – likely because the ability of the price to stay pegged to, say the US dollar, can rely on a third party.
The Howey Test is almost 80 years old. Whether lawmakers decide that it will continue to be the litmus test for the securities status of a very new type of asset remains to be seen. Crypto may simply be too new, and weird, for it.